Market Abuse: Can we leave it to the Market?

Reaction to the UK Government Foresight Report: The Future of Computer Trading in Financial Markets has been mixed (our initial thoughts on the Summary can be found here). Here, we want to talk about market abuse (covered in Foresight section 5.4.1 "leave it to market mechanisms").

Perception is Reality

The Report notes a widespread perception, particularly from the buy-side, that market abuse is prevalent and has been exacerbated by high-frequency trading. But, it can find little empirical evidence of such abuse. The question is, why not? The Foresight Project's research (and other cited work) has looked for abuse in the wrong place. Evidence is apparently unforthcoming from regulators, too. Perhaps they are wrongly equipped or organised to find it, or do not look for it effectively.

But if the buy-side's perceptions are reality, should they wait for academic evidence, or for regulators to get their act together, or abusers to have some ethical epiphany? As someone looking forward to his pension, I hope they don’t wait too long!

More Market Surveillance?

The Report asks, "how might the relationship between computer-based trading and market abuse evolve in the next ten years?" (section 5.4). Briefly, it discusses, "leave it to market mechanisms". Its discussion is weakened by conflating action that traders can take in their own defence, with what venues might do. But the interests of traders and venues are different, and no single venue could solve the entire problem even if it wanted to, as the Report correctly argues. It rather oddly adds, "leaving it to trading venue operators to police abuse thus runs the risk of harming price formation", and "increases the fragmentation of order flow across venues and aggravates order flow imbalances and volatility". If that is so, why do venues undertake any anti‑abuse surveillance at all?

Look Out for Yourself

A trader can do whatever he wants to defend himself (and his clients) from whatever he fears may be harmful. I do not need to know for certain that there is a crazed mugger lurking in the dark alley to decide it might be safer to take another route, or wait till daylight if the whole neighbourhood seems too scary. Traders can do the same. They can travel together, as it were, forming what the Report calls "ingenious new trading systems" for instance.

Or, they can look out for themselves. They could implement solutions which, as the Report puts it, assess, "order flow on each venue by examining patterns in recent activity and giving a ‘green light’ when trading is considered safe". But, the Report refers only to assessing toxicity of order flow.

Bryok goes further. We say that in deciding when, where and how to trade, the integrity of the markets - or apparent lack of integrity - should be taken into account. This should be an essential part of the order execution decision (alongside other best execution criteria: "price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order"). Not only would the trader avoid the potentially damaging lack of integrity on each trade, but over time the whole system will gain integrity. A venue that consistently loses business by failing to ensure its integrity will die or improve. A participant who repeatedly fails to trade because of his lack of integrity will correct the problem.

We think buy-side investors should insist on market integrity; sell-side firms should offer it as part of their order execution policy; execution venues should publish data including it. And that's why we've done something about it - with the creation of Bryok Integrity Metrics™.

Abuse Deniers

The Report appears to be rather dismissive of this idea - it places the words defence mechanisms and solutions in quotation markets. Further, it argues in the context of addressing perceptions of abuse by HFT, rather than dealing with the abuse itself. Why? Are the authors sceptical of the existence, scale and harm of such abuse? Because they have found no direct evidence of it? But nor have they found evidence of the absence of it. As they observe, their "research does not focus on the measurement of market abuse during the continuous phase of trading", ie it neglects the period when abusive HFT activity is likely to take place! Rather than admitting that they just don't know, the conclusion appears to be that the overwhelming opinion of institutional investors should be dismissed as unsubstantiated. Hence it is the ‘perception’ of abuse that must be dealt with, not the abuse itself.

Leave it to the Market

We find the Report over-academic yet rather ill-informed, and the conclusions trivial and missing the point. If policy makers rely on the Report alone, then don’t expect any useful change any time soon. Instead, it is the industry that perceives the problem, and it is the industry that must deal with it, or avoid the effects of it.

If participants value integrity, then "leave it to market mechanisms" turns out to be a very good idea.

Foresight: The Future of Computer Trading in Financial Markets- A Critical Review

How many leading academics and experts does it take to change a light bulb?

The Summary[1] of the final report of Foresight: The Future of Computer Trading in Financial Markets (2012)[2] suggests that 150 is not the right number. What is a light bulb? Why does it need to be changed? What does it need to be changed into? Maybe it's the light switch that needs to be changed? Is the lack of light really a problem? Research shows that blundering around in another room looking for something else does not reveal a problem with the bulb. Why can't these pesky humans put up with being kept in the dark anyway?

Our comments here refer to the Summary. We will address the full Report separately.

Given the time, money and sheer number of international academics involved in this Foresight Project, its conclusions and recommendations are banal and embarrassingly thin.

The key message at the head of the Executive Summary states "… further work is needed to inform policies in the longer term, particularly in view of likely uncertainties and lack of data. This will be vital to support evidence-based regulation ...". Well, indeed, and was not the point of the Project to produce this evidence? But what is a "likely uncertainty"? Is that like peer-reviewed woolly thinking?

As far "lack of data", this is pathetic. There is no lack of data; it is created by the terabyte by the markets every day (we actually provided some to the Project). It is simply untrue to say, as the Summary does, that "data of the quality and detail required to identify abuse are simply not available to researchers". It is available, and our own research using it reveals extensive market abuse.

Define Your Terms

The first aim of the Project was to look into "computer-based trading (CBT) in financial markets". Its focus is on "HFT and AT" (High-Frequency Trading and Algorithmic Trading). Like Fish'n'Chips. These two distinct concepts are not defined properly or differentiated. A better distinction might be between investing and trading.

Investing is what society needs, and what securities markets originally existed to support. It is inherently a relatively long-term activity.

Trading, though, is a zero sum game. It may enhance the efficiency of markets, to the benefit of investors and society, or it may be predatory - seeking to win the game at the expense of others, by fair means or foul. Or both. Most of this activity is "computer-based", much is automated.

And algorithmic trading might be rapid, but that does not make it high-frequency. HFT is really about opening and closing positions very rapidly with the aim of making money from short-term or cross market price differences (and some might say to create the differences in the first place in order to profit from them).

These terms do not provide a useful definition for the problem to be investigated. A better question would be "is HFT, defined in this way, a benefit to society, or does it damage society; in what circumstances; how could the benefits be enhanced and the damage limited or prevented?"

The second, and very different, question would be "if a trading decision is automated, what happens in extreme or unexpected situations; what happens if two trading automata interact with other unstably; how could the impact on market integrity best be minimised or removed?"

This failure to define terms and ask the right questions fatally wounds the Project before it has even begun. Little wonder it leaves the real questions unanswered, and pleads instead for "further research", involving the "wider academic community" - the luminaries of which have made such a hash of this Project. This confusion pervades the Summary.

Answer The Question

Having couched its problem as a technological one, the Project is forced to draw conclusions that might be best characterised as "the bleeding obvious" - "new technologies will continue to have profound effects on markets"; "there will be increasing availability of substantially cheaper computing power" . Well, duh!

The technology itself is irrelevant, it is the uses to which it is put, and the motives for that use. A faster box only helps a cheat to cheat faster: the problem is not the box, it is the cheat, and the system that provides the opportunities, or even justification, for his cheating.

King Canute Redux

The danger of blaming the technology is apparent in the conclusion "increasing use of computers and information technology in financial systems is likely to make them more, rather than less complex …" (true, if trite), so "… constraining and reducing such complexity will be a key challenge for policy makers." But it is simply impossible to constrain this complexity - it is inherent in the distributed nature of the markets, and of course of the technology they run on.

Rather we need to recognise this impossibility and instead deal with the unfair exploitation of the advantages available to some participants, and the disorderliness that may be created by the overall markets system itself. It is the integrity of the markets - real and perceived - not their complexity which is the real issue. We therefore do agree with conclusions on "adequate dissemination and storage of trading data" and "making sense of disclosed information and developing a better understanding of the financial system", and on "accurate, high resolution, synchronised timestamps".

However, that this "implies the need to harness the efforts of researchers" is not obvious, even if it may be self-serving, if they're the same researchers who have contributed to the Project's failure effectively to understand the financial system.

Understand Cause And Effect

CBT has reportedly benefited markets, eg by improving liquidity "as measured by bid-ask spreads". Is that how you measure liquidity? If you do not define liquidity you are not equipped to examine deleterious effects such as "periodic illiquidity", for example. (And is it really "periodic", or do they mean occasional, or unreliable, for instance.)

Falls in transaction costs are reportedly "related closely to the development of HFT". Correlation is not causation, anyone? Did we forget that MiFID introduced competition for instance. "Market prices have become more efficient", what does this even mean?

The "three main mechanisms that may lead to instabilities" are another statement of the obvious. Which of the vaunted 50 peer-reviewed academic studies came up with this pabulum?

I'm not sure whether I more dislike the incompetence, ignorance or the illiteracy.

Out Of The Mouths Of Babes…

Just when an astute and tenacious reader would be about to conclude that this is an unremittingly negative diatribe, we do have something positive to commend. The Summary, albeit somewhat circumlocutorily, does correctly observe that HFT causes a significant perceptual issue for the markets. Society needs investment markets to be fair and orderly, and to be perceived to be so. Otherwise confidence and participation in the markets are damaged.

However, it goes on to say "regulators and policy makers can influence perceptions, even if definitive evidence on the extent of abuse will not be available to settle the debate". How does that make sense? The regulators should say "look, we don't know whether there's a problem or not, despite the extensive Foresight Project, but don't worry your pretty little heads, it's only your perception that's at fault"?

Why not put the onus on the cause of the perceptual problem: the HFTs. Prove you're beneficial, prove you're not abusive, prove you cannot cause instability or "endogenous" risks. And I don't mean turning up at conferences or workshops with spurious arguments or irrelevant "evidence", I mean prove it. Otherwise you can whistle for your trading licence.

Start Making Sense

While we cannot agree in general with the Summary conclusions - since we think are they based on wrongly defined and poorly researched premises - some are sensible or unobjectionable.

In particular we support the idea "to learn lessons from other safety-critical industries, and to use these to inform the effective management of systemic risk in financial systems". Indeed we have undertaken our own research into this. We do not agree that this should be "in the longer term", but would be useful right now.

We also support "making surveillance of financial markets easier". However the specific conclusion; "development of software for automated forensic analysis of adverse/extreme market events", seems to have come from leftfield. As useful as this would doubtless be, surely regulators first need data and tools to analyse it properly. They need fully detailed, timestamped orderbook event data (not just trades, and not just on request), allowing each actor in the order lifecycle to be identified. They need systems able to accept, process, store and retrieve this data - in the order of a billion events daily. They need tools to visualise the data, and to perform advanced mathematical and statistical analysis of it in multiple dimensions. We have also researched such tools.

Like life, liberty and the pursuit of happiness, many assume that the integrity of securities markets is a self-evidently good thing. IOSCO defines market integrity as "the extent to which a market operates in a manner that is, and is perceived to be, fair and orderly and where effective rules are in place and enforced by regulators so that confidence and participation in the market is fostered."

Others, perhaps more cynical, or more realistic, would say that today's market self-evidently lack integrity. If they did not, the European Commission could not have arrived at an estimate of €13.3 Bn of the cost to investors of abuse of equity markets in the EU alone, for instance. Deliberate market abuse is a major factor impairing market integrity - and is rightly proscribed (though how effectively these proscriptions are enforced is questionnable). However, technical factors, and unexpected systemic behaviour can also impair market integrity. We are not aware of any sensible estimates of the costs due to such factors, but the 2010 Flash Crash offers evidence of their serious consequences.

In this context the current debate over the effects of HFT on market integrity misses the point: the effort and emotion invested in this debate indicates, in IOSCO's terms, that there is a widespread perception - justified or not - that HFT may cause markets to be unfair or disorderly, and hence confidence and participation in the markets is damaged. Without wanting to join this debate we would observe that, if perception is reality, and market integrity depends on perception - as well as objective fact - then HFT has a perception problem, and so do markets that support it.

But while such debates rage, and regulators and legislators get their act together to define and enforce appropriate rules, the world continues to spin, and society needs investors to continue to invest through securities markets. We cannot and need not wait for some perfect system to emerge, even if we could all agree what that system should look like.

Better Execution

So, we have to deal with the world as it is. That means we should not delude ourselves that it is somehow different, or that the consequences are trivial, just-the-way-things-are, or someone else's problem. The cost to investors of neglecting market integrity as a best execution criterion is enormous, as the EC's estimate shows. Conversely, taking market integrity into account when deciding when, where and how to trade creates a substantial opportunity for better execution.

That means when a decision on when, where and how to trade is made, the integrity of the markets - or apparent lack of integrity - should be taken into account alongside "price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order."[1] Buy-side investors should insist on it; sell-side firms should offer it as part of their order execution policy; execution venues should publish data including it[2].

[1] MiFID Article 21, on best execution: a firm must take all reasonable steps to obtain the best possible result for the investor.